8 ways higher interest rates could impact your portfolio

I think the financial media spends too much time speculating about when interest rates will rise. At times, it seems that's all they do!

That's not to say that an increase in rates is unimportant. So, here are eight ways it could affect your investments.

1. In the short term, higher rates make bonds less attractive

While we focus on shares at The Motley Fool, most investors will hopefully have diversified portfolios including some bonds. One impact of rising rates would likely be falling bond prices, especially UK government bonds (gilts).

If rates are rising because the economy is doing well then corporate bonds could hold up, because traders could be more confident about their prospects. Gilts are always deemed 'risk free' though, and assumed never to default. The UK can print money to pay them if it needs to!

Without getting bogged down in bond mathematics, just know that as interest rates rise, bond yields rise to reflect that, causing the price of existing bonds to fall. This means that bond funds or ETFs you own could slide as rates rise.

2. Longer term, cash and bonds become more attractive

Bond prices then would fall as the market adjusted to higher rates. But after the rate rising cycle slowed or stopped, yields would find a new equilibrium.

At this point, the yield from bonds would be higher than before rates started rising. Investors comparing bonds and shares might now find bonds looking more attractive than shares, and decide to sell some shares to buy more bonds.

As I write the UK 10-year gilt is yielding about 1.2%, and the FTSE 100 dividend yield is around 3.7%. On this one measure, shares look better value than government bonds.

But what if you got, say, 3% on gilts? While still lower than the likely income yield from the FTSE, it is more secure. Some investors might decide it's not worth holding so much in shares when they can get a decent payout from bonds, and this could prompt a sell-off in equities.

3. Dividend paying companies are less appealing as bond proxies

Years of near-zero interest rates have made so-called 'bond proxy' shares popular. These are stable companies deemed to pay very secure dividends - think big consumer companies like Unilever or utilities like SSE.

Bond proxies have attracted risk-averse investors who perhaps don't really want to hold equities, but have felt compelled to by paltry bond yields.

As rates rise, such shares could be most affected. Sure enough, fund group Vanguard has published research showing that in periods of rising interest rates, higher yielding shares and those with fast-growing dividends tend to be hit harder than the wider market.

4. Discount rates rise, reducing multiples on shares

It's not just dividend-paying shares that may be hit if rates rise. All shares could be affected by higher government bond yields.

The models analysts use to try to calculate the fair value of shares utilise a risk-free government yield as a key input. As that yield rises, the implied value of a share spat out by such a model falls. In theory, equity investors would reduce what they're willing to pay for shares.

5. Over-leveraged companies may suffer

The examples so far have been rather esoteric, in that they've concerned prices, yields, and other investing metrics. But actually, central banks raise and lower interest rates more to have an impact on the real economy. Higher rates curb economic enthusiasm and dampen growth. Lower rates are supportive of borrowing and expansion.

Central banks raising rates to dampen excess - usually to curb inflation expectations - don't do so to cause difficulties to over-stretched firms. Nevertheless, firms carrying too much debt may struggle if they have to refinance maturing loans at higher rates. If higher rates cause a wider slowdown or recession, the impact on trading and cash flows could further worsen things.

Some people believe there are hordes of zombie companies out there, limping along thanks to cheap debt. If rates rise quickly, we could soon find out if they're right!

6. Consumers could struggle, too

Unsecured household debt is near a record while Britain's relentlessly rising house prices have seen buyers take on huge mortgages. It's all arguably only made affordable by today's low rates. The Bank of England recently asked lenders to set aside more than £11bn more to protect against this rising debt burden turning sour.

Rising interest rates coupled with stagnant wages could cause more defaults and bankruptcies. It could certainly curtail consumer spending, which could hit companies from retailers and restaurants to holiday firms.

7. However the pound could strengthen

One bright side to higher interest rates could be if they dampen down the inflation Britain has been importing since the pound's collapse last summer.

If rates rise, holding sterling should be more attractive to foreign investors since they will be getting paid more for their trouble. This could cause the pound to strengthen against other currencies, making imports cheaper and holding down inflation.

8. Banks might be happier, too

Higher interest rates could also be good for any High Street banks in your portfolio - provided rate rises aren't sudden or severe enough to push customers over the financial edge.

Higher rates should enable banks to pad their margins by raising the cost of loans faster than they increase what they pay on savings. This could boost returns on equity, and lead to higher multiples for the sector.

A final caveat

I've used words like "could" and "should" above, because the truth is nobody knows exactly what will happen when our multi-century low interest rates finally get off the floor. Our portfolios may suffer for a little while, but at least we'll all get an education!

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